Behind Freddie’s “profit,” rising NPAs

Tags:

Late yesterday Freddie Mac surprised markets by reporting a profit and by not requesting additional bailout money from Treasury. Before we celebrate, however, let’s consider a few revealing footnotes from the company’s quarterly filing. But first, some key financial ratios.

As you can see, non-performing assets are still rising quickly. (Click table to enlarge in new window)

As for the filing footnotes, we see that Freddie’s profit line got a big assist from FASB’s new fair value accounting rules:

Q2:

… the company recognized $10.5 billion in total other-than-temporary impairments of AFS securities. Included in this amount were $2.2 billion of credit-related impairments recognized in earnings …. Also included in total other-than-temporary impairments were $8.3 billion of non-credit related impairmentsthat were recognized in accumulated other comprehensive income (loss) (AOCI).

Q1:

During the first quarter of 2009, prior to its … adoption of the new accounting standard, the company recorded $7.1 billion of security impairments on its AFS securities in earnings,reflecting both credit-related and non-credit-related impairments.

Overall, accounting changes increased equity $5.1 billion according to Freddie.. Higher equity equals higher net worth. As long as the company maintains positive net worth, Treasury doesn’t have to provide more bailout funds. Freddie’s total bailout to date, by the way, is $51.7 billion.

What FASB giveth, it can also taketh. Revisions to other accounting rules will require Fred to bring off balance sheet assets back onto the balance sheet:

Upon the adoption of SFAS 166 and SFAS 167 [on 1/1/10], we will be required to consolidate [off balance sheet assets] in our financial statements, which could have a significant impact on our net worth. Such consolidation could also significantly increase our required level of capital under existing capital rules …

I doubt the significant impact is going to be positive. And remember, whenever Freddie’s net worth goes negative, that triggers another bailout payment from Treasury.

As for any talk that Fan and Fred will be wound down over time, that’s certainly not in the near future. You can see in the table above that the company’s portfolio of mortgages is not shrinking.*

Rolfe, how does shifting a loss from NI to AOCI inflate Shareholder Equity? Retained Earnings is still reduced by AOCI (and subsequently anything allocated to it this quarter), thus Shareholder Equity properly reflects these losses.

Thanks for the correction Kyle. Here’s the crucial paragraph from the earnings release.

On April 1, 2009, the company prospectively adopted FSP FAS 115-2 and FAS 124-2. The new accounting guidance revised the recognition, measurement and presentation for other-than-temporary impairments on AFS securities the company holds. As a result of the adoption, the company recognized a cumulative-effect adjustment of $15.0 billion to its opening balance of retained earnings (accumulated deficit) on April 1, 2009, with a corresponding adjustment of $(9.9) billion, net of tax, to AOCI. The difference primarily represents the release of the previously recorded valuation allowance against the deferred tax asset that is no longer required upon adoption of FSP FAS 115-2 and FAS 124-2. Thus, as a result of the adoption of the new accounting guidance, the company’s total equity increased by $5.1 billion.

I just get kind of annoyed because people are ALWAYS parroting the FSP 157-4 change as this destruction of FV accounting principles, and clearly, it has had little to no effect. FSP 115-2 and 124-2, issued concurrently with 157-4, have certainly had “implications,” such as the one you present in this article, but I think anyone with a modicum of securities analysis or accounting education can identify where the changes occurred. Bottom line is that people (mainstream and blogosphere both) act like those changes (157-4, 115-2, 124-2) are hiding losses that would have been recognized otherwise, and that is quite simply not the case. Anyway, you just gave me a place to vent I always enjoy your work, thanks!

But the new fair value rules DO help companies hide losses by shifting them off the P&L, no? “Non credit related” OTTIs no longer impact EPS. Yeah, they’re still in AOCI, but the headline figures are massaged. Freddie is exhibit A. The headline from the Q2 report was that they turned a profit….

To channel Bill Clinton, I guess that depends on your definition of “hide.” I mean, anyone who looks at the F/S should be able to see the shift with a minimal amount of effort. Hell, you don’t even have to look for it, they’re required to spell it out for you. If Joe Investor is fooled because all he does is read the MarketWatch or CNBC headline, is that really important? He’s not moving the market anyway. To be clear, I’m not disagreeing with you on your last comment, I just can’t see how it truly makes a difference. Do money managers/other professionals actually not read the F/S or have such a poor working knowledge of accounting that this fools them?

Good job analyzing the notes. If more people had looked in depth at the smoke-and-mirrors corporate America has put out for the past 2 decades or so maybe we wouldn’t be in the predicament that we are.

Hah, maybe you are right. My initial [and continued] reaction when FASB “folded” back in March was that they changed stuff without ever changing anything, to get politicians [clearly displaying their lack of real concern or understanding of anything] off of their backs.

Rolfe: I enjoy reading your postings!
I thought Fannie and Freedie have balance sheets and guarantee Agency RMBS securities. What constituits their off balance sheets assets? Also, because they are in Conservativeship, are the taxpayers also ultimately on the hook for the Agencies off balance sheet assets/liabilities?
Thanks